Medical device companies can be excellent investments thanks to their unique mix of innovation-driven development, solid margins, and massive appreciation potential. Still, investors would do well to avoid businesses that feature some of the industry's bugbears like indebtedness, overly high valuations, and small addressable markets.
On that note, DexCom (DXCM 0.62%) has some of the trappings that can make for a winner. Its returns have crushed the market over the last five years, with its shares rising by more than 487% against the market's rise of nearly 106%. Could it repeat this feat in the future? In my view, it's possible, but that doesn't necessarily make it the right stock for everyone.
Image source: Getty Images.
Why this stock might be a good pick for your portfolio
To appreciate why this company is worth considering for purchase, it's key to understand its product: continuous glucose monitors (CGMs). DexCom's CGMs help people with type 2 diabetes to measure and therefore regulate their body's glucose levels. Using a CGM instead of a traditional pin-prick blood test is preferable for several reasons, starting with patient comfort.
People who wear the company's disposable CGMs don't need to repeatedly poke themselves to keep their blood glucose levels in their target range. Plus, CGMs take more measurements than someone with a finger prick test would be willing to do throughout the day, which means that patients get alerted to issues sooner than they would otherwise. And they might even be saving money on insulin by using one of the company's CGMs, too.
Obviously, those benefits are appealing enough to attract new customers in droves. Over the last five years, its annual sales have ballooned 241%, and in 2022 management expects to bring in as much as $2.9 billion.
There's no guarantee of an encore, but investors can take heart that the company is still operating with the same successful business model as before. In fact, there's a strong argument to be made that it's actually becoming more efficient with that business model over time, which is appealing.
Over the last three years, its annual cost of goods sold (COGS) and its selling, general, and administrative (SG&A) expenses have both fallen as a share of annual revenue, which drove its total expenses to also shrink as a proportion of sales. In the same period, its annual investments in research and development (R&D) grew significantly as a percentage of revenue, suggesting that management is judiciously using the cost savings to reinvest for future growth.
DXCM Cost of Goods Sold (% of Annual Revenues) data by YCharts
And all of the above are big green flags for investors.
Don't overlook competitors and valuation risks
The bear case against DexCom is that it's competing in an increasingly crowded industry that includes significantly more powerful competitors.
For example, healthcare giant Abbott Laboratories is making headway into the market for CGMs as are many others. Though it has the benefit of focusing entirely on CGMs rather than other medical devices like some of its adversaries, DexCom still faces a fight for market share once the market is saturated. Given that management is expecting its total addressable market (TAM) of eligible patients to triple by the second half of 2023, however, saturation probably isn't coming soon.
Nonetheless, with its narrow profit margin of 6.3%, there isn't much slack for management to work with to actually win the market share fight when it occurs. But there's always the hope of the margin improving in the next few years -- once the company concludes the manufacturing scale-up of its latest CGM.
The other trouble with this stock is that its valuation is currently in the stratosphere. Its price-to-earnings (P/E) ratio is above 293, putting it massively higher than the industry's average of about 42. In one sense, that's a plus because it means the market has high expectations for the company's growth.
For price-sensitive investors, such a high multiple is a dealbreaker. And even for those who prefer to chase growth stocks, multiples that high are a major red flag as they leave the stock vulnerable to a collapse in the event of a flight to value. At its current valuation, even a relatively minor earnings miss might leave a few serious dents in your investment.
Therefore, while I've taken more than one stance in favor of purchasing the stock in the past, it's valued too expensively for me at the moment.
